Why it’s hard to invest sensibly

By Felix Salmon

December 28, 2011

It’s that time of year when resolutions get made, and people have a bit of free time on their hands, and so thoughts turn to financial planning. This is a good thing. Top priority should always be liability management: make sure you’re not paying more interest than you need to, especially since interest rates are so low right now. If you’re carrying a substantial balance on your credit cards which isn’t likely to be paid off any time soon, look hard for some kind of loan which can pay that balance off.

Once you’re done with your liabilities, move on to your cashflows: put together a budget, set up automatic transfers into savings, that sort of thing.

Finally, and least importantly, there’s assets: where you should you invest your savings? This is the bit which people actually like doing — or certain people, anyway, including a quite enormous proportion of the readers of finance blogs and financial journalism.

The syllogism goes something like this: if you’re investing savings, that makes you an investor. If you’re an investor, then you should know what you’re doing. So go out there, get informed, make good decisions, and watch your net worth soar as you make your money work for you. Companies like thestreet.com and the Motley Fool make millions of dollars by selling information and investment advice to such people; Barron’s has been doing it for more than 90 years.

But you shouldn’t buy what they’re selling, even when it’s free. Trying to respond to global events so as to maximize your returns and minimize your risk is a great idea, in theory. But for individual investors — for you — it doesn’t work. Inevitably, there will be comments on this post from people saying that it does work, for them: that they’re successful individual investors. Those commenters might or might not be telling the whole truth. But even if they are, you’re not going to be able to replicate their success.

Henry Blodget has a fantastic post explaining why this is a game you simply should not get involved in.

If you’re an individual with some money to invest, the first thing you need to know if you want to invest intelligently is that you shouldn’t play the Losers’ Game, following global economics and markets and investment advice and trying to make smart decisions along the way.

If you play that investment game, you’re almost certain to lose.

If you want to invest intelligently, the first thing you should do is ignore 99.9% of what you hear in the financial media.

Because, if your goal is to invest intelligently, what you hear in the financial media is mostly distracting noise that will trick you into making expensive mistakes.

Go read the whole thing, it’s very good. And then, just for giggles, read some of the financial media. How would you “play Europe”, for instance, if you read the WSJ’s “Ahead of the Market” column?

Mr. Masterson worries that Europe could fall into recession and that China could suffer a sharp slowdown. “If that scenario plays out and we get a global slowing, then the U.S. will slow as well,” he says. “We’re all connected, and the strength in the U.S. markets now will be perceived with the benefit of a hindsight as being somewhat optimistic.”

On the other hand, some investors argue that European and Asian stocks could rebound dramatically next year, leaving the U.S. behind, if the sense of crisis fades. That could unwind the safe-haven flows into the U.S. this year.

The fact is that you can’t get “ahead of the market”: the market will always be ahead of you. You really only have one possible advantage over the market as a whole: if you’re investing over a very long time horizon — 20 years or more, say — then you can ride out volatility and take advantage of illiquidity premiums. But both of those things are easier said than done, especially for people who follow the news. And illiquidity premiums are hard to find for small investors: investable products like stocks and mutual funds tend to be run by companies which are constantly marking to — and trying to anticipate — market reactions.

But here’s the thing: simply following Blodget’s good advice — buy a handful of index funds, and rebalance automatically when the allocations get out of whack — is much harder than it should be. It’s hard enough that a company called Betterment feels comfortable charging a fee of 0.9% of all your assets, every year, just for doing it for you. The fee continues to rise as your asset base rises, but starts falling as a percentage once it goes over $25,000: if you have a nest egg of, say, $200,000, then Betterment will charge you $1,250 a year to put it in index funds: that’s 0.625%, over and above all of the fees on the index funds it’s investing in. To give an idea of what that means, $200,000 compounded at 7% over 20 years will become $770,000. The same amount compounded at 7.625% over 20 years will become $870,000. That’s a difference of $100,000.

For people who try to save a certain amount of money every paycheck, rebalancing should be done dynamically — you just buy whatever you need to buy to keep your asset allocation stable, and you never sell anything. But no one wants to do that kind of math manually every paycheck. One thing you can do is simply put all of your money into a single balanced index fund, like a target-date fund; that solves a lot of problems while adding a chunk of idiosyncratic fund risk. But in general the world of financial services is designed to extract as much money from you as possible, by offering as many unnecessary products and bits of advice as it can. Which is why following Blodget’s advice is much easier said than done.

Update: As various commenters and Timothy Lee have noted, there is at least one easy way to get a low-cost, diversified, set-it-and-forget-it portfolio: buy a Vanguard target-date fund and just keep adding money to it regularly over time. This is very good advice.